Dynamic Macroeconomics

15.1.4 The Impact of Aggregate Demand Policies
Equations 
(15.8)
and 
(15.11)
and 
figure 15.3
can be used to analyze
economic fluctuations and the impact of macroeconomic policy on both
output (employment) and the price level in the standard Keynesian model.
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First, for given nominal wages, an economy can be trapped in a short-run
equilibrium with high unemployment. Suppose that the entire workforce is
equal to N. From the production function 
(15.10)
, full employment output and
income is given by
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Consider 
figure 15.4
. The original equilibrium is at full employment
output. A negative disturbance in aggregate demand shifts the aggregate
demand curve AD to the left. In the new short-run equilibrium E
1
, income and
employment decline, and the price level falls. Because of the rigidity of
nominal wages, the economy moves to an equilibrium with lower real output
and employment and positive unemployment.

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Figure 15.4
Aggregate demand disturbances and their effects on aggregate output and the price level.
If nominal wages were not fixed in the short run and adjusted to achieve
full employment, the aggregate supply function would be perpendicular to the
level of full employment, and changes in aggregate demand would only result
in changes in the price level. Consequently, with full flexibility of wages and
prices, this model has the same properties as a classical model.
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This model can also be used to address the effects of disturbances to
aggregate supply. Consider 
figure 15.5
. The original equilibrium is at full
employment output. A negative disturbance in aggregate supply, such as a
negative productivity shock, shifts the aggregate supply curve AS to the left.
In the new short-run equilibrium, income and employment declines, and the
price level rises. Because of the rigidity of nominal wages, the economy
moves to an equilibrium with lower real output and employment, a higher
price level, and positive unemployment.
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